Concerns on tax implications, priority sector loan targets and borrowing limits will be on the top of the agenda of foreign banks in India when they meet the banking regulator this week, even as the deadline to offer feedback on a Reserve Bank of India (RBI) discussion paper on foreign banks’ play in India expires on March 14, 2011..

RBI wants foreign banks in India to incorporate locally. Most want to do so as they find Indian market attractive, but they have many concerns.

The RBI discussion paper, released on 21 January, said the regulator prefers foreign banks to operate in India as subsidiaries of their parents rather than branches, as is the case currently.

RBI spoke about a “less restrictive branch expansion policy”, but was silent on the tax liability of foreign banks due to this move.

Stuart Davis, India chief executive officer at Hongkong and Shanghai Banking Corp. Ltd (HSBC) said his bank is ready to incorporate locally, but concerns remain on the transition.

“The positives include a possible reductionin the tax we pay (after local incorporation), increase in branches, but the tax liabilities in the transitional phase are not clear,” he said.

Under the current tax rules, a branch of a foreign bank in India is treated as a foreign firm. If a foreign bank chooses to incorporate locally, it will have to buy the business of the branches, requiring the parent to pay capital gains tax for the transaction.

Anurag Jain, partner at tax consultancy firm, BMR and Associates, said foreign lenders wanting to convert into wholly owned subsidiaries cannot go for any kind of equity dilution, including issue of Indian depository receipts (IDR), as it would trigger the capital gains tax.

“Any kind of dilution by the parent, including that for IDR issue can trigger this tax liability. However, those banks, which have serious long-term plans for India, are unlikely to dilute the holding. Even if the parent is acquired, they may prefer to keep the holding in the local subsidiary intact,” Jain said.

In June 2010, UK-based lender Standard Chartered Plc. had issued IDRs, becoming the first foreign bank to do so in the country, to raise around Rs 2,490 crore.

Davis said foreign banks will also face challenges on single borrowing limits and capital management. Banks in India are not allowed to lend more than 15 per cent of their net worth to a single company and more than 40 per cent to a corporate group.

Clarifications on tax is also at top of the mind of Neeraj Swaroop, regional chief executive officer, India and South Asia, at Standard Chartered Bank.

“But the biggest positive is how foreign banks can play a bigger role in the sector and economy, which is a good starting point. We will give our feedback to the RBI,” he said.

Other concerns include meeting priority sector targets, which some foreign banks say are stiff.

Indian banks have to give 40 per cent of their loans to the so-called priority sector, which includes agriculture, small and medium enterprises, exports and home loans up to Rs 15 lakh.

Agriculture at 20 per cent of the lending forms the largest part of the priority sector loans.

Foreign banks are skeptical about meeting these targets because of their limited reach, especially in the rural areas.

In an interview last week, Piyush Gupta, chief executive officer at DBS Bank Ltd, said the “priority sector lending” is something that the bank is “trying to understand”.

“For a bank like DBS, which is coming into the country and building business, it is really difficult to reach out to farmers. We want to explore whether there are any other opportunities for us to participate in agricultural lending through schemes like rural bonds and agricultural bonds, which will make it possible for us to reach out to this segment without having to build a distribution network,” he said.

RBI has given foreign banks five years to meet these targets. Many of these banks are skeptical about this because of their limited reach, but they are not opposing RBI’s plan for local incorporation.

Vaibhav Agrawal, vice-president, research at Angel Broking Ltd, said foreign banks may try to get a better deal by bargaining on some of the conditions set by RBI, but they cannot afford to say no. “They need to expand in India; it’s a huge opportunity. There is a huge demand-supply gap in credit and they would not like to miss it,” he said.

“The strategy is to grow organically in India because the next five years are going to present a number of opportunities,” HSBC’s Davis had said last week after the bank announced a 82 per cent jump in annual profit from India, recording the largest ever profit before tax in its 145 years in the country at $679 million in 2010. HSBC has 50 branches in India.

For Standard Chartered, the largest foreign bank in India with 94 branches, the local market is now the largest contributor to the profit among countries. Last year, income from India rose nearly 12 per cent to $2.02 billion, continuing the 38 per cent compounded annual growth rate in the past five years.